Part of Tuesday’s Roundtable with Scott Dyreng focused on how social norms might interact with accounting and financial reporting.  In the typed and voice chat, reference was made to a paper by Paul Fischer and Steven Huddart, titled “Optimal Contracting with Endogenous Social Norms” (American Economic Review, Sept 2008, 1459-75).  I really like the paper, as it alters the traditional principal-agent model so that the agent’s utility function also depends on how the agent is perceived by his/her peer group.  The abstract is as follows:

Research in sociology and ethics suggests that individuals adhere to social norms of behavior established by their peers. Within an agency framework, we model endogenous social norms by assuming that each agent’s cost of implementing an action depends on the social norm for that action, defined to be the average level of that action chosen by the agent’s peer group. We show how endogenous social norms alter the effectiveness of monetary incentives, determine whether it is optimal to group agents in a single or two separate organizations, and may give rise to a costly adverse selection problem when agents’ sensitivities to social norms are unobservable.

The result is that if the principal knows the prevailing social norm and how conforming to the norm either enhances or detracts from the performance of the agent, then the principal will alter the contract in light of the norms. 

I wonder if extending the notion of a norm to an investor’s utility function might help explain market bubbles and credit crunches?  I guess this is the idea behind herding, but by calling it complying with a norm, the investor sounds less irrational.

I also wonder if the strength of norms affects whether a country or region adopts financial reporting guidance that is more or less rules based?  If norms push people to comply with the spirit of the professional guidance, then a principles based system might work well.  If norms reinforce a compliance mentality (e.g., income tax preparation in the U.S.), then rules arise endogenously. 

FYI, the Fischer and Huddart paper won the University of Oklahoma’s Glen McLaughlin Prize for Research in Accounting Ethics in 2005.  The winning paper for 2010 was just announced: “Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get it Wrong?” by Prawitt Sharp, and Wood.  Click here for more information on the McLaughlin Prize